In a previous blog post, The Risks of Financial Leverage in Small Business Acquisitions, I discussed the increased number of online influencers. They are promoting small business acquisitions as a path to creating wealth. While there are plenty of entrepreneurs who have become very wealthy acquiring small businesses, these deals are not without risk.
Influencers are not fiduciaries. They’re in the attention business. They get a lot more “clicks” and “likes” selling optimism than discussing risk. But serious investors follow Warren Buffett’s number one rule of investing: “don’t lose money.” Risk analysis is at the heart of investment research, whether buying stocks, real estate, small businesses, or any other asset.
Financial Leverage: The Double-Edged Sword
One risk of buying a business that I discussed in that previous post is the risk of financial leverage (i.e., the use of borrowed money). Leverage is a double-edged sword. Leverage can greatly multiply equity gains but can also multiply losses. Additionally, most debt financing in a small business acquisition is “full recourse,” requiring a personal guarantee from the borrower. Unsuccessful deals, in other words, can lead to losses greater than the investor’s original equity investment.
The Critical Role of Operators in Small Business Success
Financial leverage is not the only risk in purchasing a small business. There are plenty of operating risks that need to be considered. And the biggest operating risk, in my opinion, is having an ineffective operator to run the business.
I’m speaking of businesses purchased as investments. Business buyers who are looking to operate the business themselves are in a different category:
- Owner-operators are betting on themselves.
- Investors are betting on others to successfully manage the business.
Businesses are not bonds or commercial real estate. Businesses require people to run them. Most small-to-medium sized businesses (SMBs) are owner-operated. When the owner steps down, someone must come in and manage the company. [For a quick breakdown, check out my YouTube short on this topic, or dive deeper by listening to Episode 6 of Fundamentals Unfiltered for the full discussion.] Get the wrong person in that position, and you could be staring down your creditors in short order.
Consider the challenge of managing the relationships that the owner built. The retiring owner likely spent many years forging relationships with employees, customers, and suppliers. Among a thousand other challengers, the newly installed operator must earn the trust of those parties. Finding recent business school graduates who understand finance, operations management, and marketing is much easier. It is harder to find managers with the “soft skills” needed to effectively build relationships and lead a team of employees.
Lessons From Experience
I have been investing in public securities and private businesses for over two decades. By far, the largest losses that I have faced have been from mismanaged small businesses. My own experience has shown this. Most investors like me are far better judges of managerial talent. They excel when looking at a long operating history. It is tempting to think there are many seasoned operators. We might think they can be found through job boards or on LinkedIn. But great operators, like great stocks, are rare.
The “buy a business, install an operator” model sounds great. And, again, there are plenty of success stories. In my experience, this works far better with businesses doing at least $1 million in earnings. Such businesses have the resources to attract more seasoned managers.
With typical SMBs, however, the buyer is unlikely to pay a high base salary. Instead, they rely on performance incentives tied to growth and profitability targets. It can be hard to find seasoned operators willing to take that risk. This is particularly true if they are not in charge of capital allocation decisions.
Final Thoughts
I’m not trying to dissuade anyone from buying a business. But finding trustworthy and effective operators is a lot harder than finding a business with sound economics. Personally, I stopped trusting my “people radar” a long time ago.
Summary
Small business acquisition can be a wealth-building opportunity—but it carries serious risks. Beyond financial leverage, the greatest challenge is management risk. Replacing an owner with a capable operator is far more difficult than most investors expect, and missteps can lead to steep losses.
Key Takeaways: Small Business Investment Risks
- Always conduct thorough risk analysis before any business acquisition
- Beware financial leverage and full recourse loans
- Successful small business investing depends as much on finding skilled operators as it does on buying strong businesses
- Prioritize soft skills and relationship-building when vetting management
- High optimism from influencers shouldn’t blind investors to sobering realities
